Expansion of the Availability of In-Plan Roth Transfers
The American Taxpayer Relief Act of 2012 (the Act) (legislation signed to avoid the "fiscal cliff"), authorizes 401(k), 403(b) and 457(b) plans to include a feature that allows members and certain beneficiaries to transfer any vested amount in their defined contribution account to a designated Roth after-tax account, regardless of whether the member is eligible for a distribution.
Summary of the Act
This new law applies to transfers occurring after Dec. 31, 2012, but only if the plan provides for such a transfer. Under prior law, in-plan rollovers could be made from a vested account to a Designated Roth Account, but only when the participant or beneficiary was eligible for a distribution. Under the Act, the transfer can occur prior to a distributable event. This means that an employee age 40 could be permitted to transfer the balance of her 457(b) plan (including employee and employer contributions, plus the applicable earnings) to a Designated Roth Account within the same plan (if plan terms permit), even though she is not eligible for a distribution. The plan would not be making an actual distribution to the member, but instead, transferring a pre-tax account into an after-tax account. The result of this transfer would be taxable income to the member reported for the year in which the transfer occurred.
In considering whether or not to amend your plan to permit such a transfer, it is crucial to explain to members and spousal beneficiaries that pre-tax amounts transferred to a Designated Roth Account will be taxed prior to distribution as ordinary income. Individuals electing to transfer funds to a Designated Roth Account must, therefore, have funds outside of the plan to pay the taxes. The taxes must be paid (along with other taxes due) for the year in which the transfer occurs.
The transfer is essentially treated as a distribution (although no actual money changes hands). The effect of transferring funds under this provision is that at the time the plan does provide the member/beneficiary a distribution, the balance in the Roth account—which includes earnings—will be tax-free (assuming the distribution is a "qualified" distribution). A qualified distribution is a distribution that occurs at least five years after the Roth account is established and occurs on account of death, disability, or after the member attains age 59 ½.
In order for members to be eligible to make a transfer to the Designated Roth Account under the Act, their retirement plan must provide for a qualified Roth contribution program (i.e., a program that permits designations by members of contributions as Roth after-tax contributions and separately accounts for designated Roth contributions). Transfer elections may be made by current and former employees, as well as spousal alternate payees and beneficiaries.
Items to Begin Discussing and to Add to Your Plan's 2013 "TO DO" List:
Consider draft of plan language. Plan language to allow for Roth in-plan transfers may begin to be drafted, although the final amendment may be delayed until later in the year in hopes of IRS guidance that provides additional clarity concerning plan design questions such as:
Can transfer options be limited to certain types of contributions (e.g., elective deferrals or matching contributions, etc.) or certain percentages of accounts? The law allows for any pre-tax contribution and any portion of such account to be transferred, but plans may wish to limit types or amounts of transfers for administrative ease. Similarly, we believe that the timing of the transfers (e.g., monthly, quarterly, annually, etc.) would be left to the plans' discretion, but confirmation would be helpful.
Clarity around who is eligible to make transfers to Roth accounts (i.e., spousal and nonspousal beneficiaries?).
Confirmation that the transfer only applies to vested amounts or that a plan can permit only vested amounts to be transferred. (Note – even if non-vested amounts can be transferred it seems as though an administrative burden may be created in the case of employee terminations before vesting and resulting forfeitures.)
Whether investment selections could be, must be, or should be, offered to be changed at the time of transfer. For example, if a member has all of her pre-tax account invested in a target fund at the time she transfers the account to a Designated Roth Account, should she be offered a chance to change where the funds are invested at the time of the transfer? If no change is selected, is the plan administrator free to leave the funds as currently invested? Are there any unique fiduciary or notice requirements? We believe there are no unique issues here and that members should be able to choose to change investment directions at the time of transfer (particularly if the funds allow daily investment changes). It appears the plan could have a default to leave the money as currently invested, but confirmation of this approach would be helpful.
Prepare a list of communication materials to be updated for members. Revisions to plan summaries will need to be made along with any highlight summaries, fact sheets, etc., that are posted or provided to members explaining their benefits. Plan administrators may want to begin preparing a list of all documents that will need to be revised or created to accommodate the new transfer feature. Also include required notices, such as updating the Special Tax Notice, and any withholding materials.
Modify administrative processes (including forms) and plan for staff training. Will administrative processes need to be created/modified to allow for the Roth transfers? Consider preparing a list of forms that will need to be modified or created to handle the new transfer process. Also list items that need to be further understood and then communicated to staff, (e.g., how will the new transfer process affect the Form 1099-R reporting requirements? How will the changes be communicated to staff? Will there be any system coding changes needed? How will a transfer process work? What extra recordkeeping will be necessary?)
This new transfer option applies to transfers after Dec. 31, 2012. Although the IRS has not yet established timing requirements for amending plans, plan sponsors wanting to include a Roth in-plan transfer option under the Act should add this amendment and other items discussed above to their 2013 "TO DO" list right away and start discussing plan design options. It is not too early to begin brain-storming about this issue and getting initial questions and action steps compiled.
This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.